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Saturday, July 21, 2012

21/7/2012: Sunday Times July 1, 2012 - Not a 'stimulus' again...

An unedited version of my Sunday Times article from July 1.

One of the points of contention in modern
economics is the role of fiscal spending shocks on economic growth. Various
empirical estimates suggest Irish fiscal multiplier at 0.3-0.4, implying that
for every euro of additional Government spending we should get a €1.30-€1.40 in
GDP uplift. However, these are based on models that do not take into the
account our current conditions. Despite this fact, Irish policymakers continue
talking about the need for Government to stimulate the economy, while various
think tanks continue to argue that Ireland should abandon fiscal stabilization
or more aggressively tax private incomes to deliver a boost to our spending.

International research on this matter is more
advanced, although it too leaves much room for a debate.

June 2012 IMF working paper titled “What
Determines Government Spending Multipliers?” by Giancarlo Corsetti, Andre Meier
and Gernot Muller (June 2012) studied the effects of government spending on the
economy under the variety of macroeconomic conditions.

What
IMF researchers did find is that the initial conditions for stimulus do matter
in determining its effectiveness – an issue generally ignored in the domestic
debates about the topic.

Under
a pegged exchange rate regime, similar to
Ireland’s but still allowing for some exchange rate and interest rates
adjustments, trade balance is likely to worsen in response to a fiscal
stimulus, while output can be expected to rise. Domestic investment and
consumption will decline in response to the positive stimulus shock. These
factors are likely to be even more pronounced in the case of Ireland’s currency
‘peg’ that permits no adjustment in real exchange rate except via domestic
inflation.

The role of weak public
finances in determining the effectiveness of fiscal spending stimulus is also
revealing. The study defines fiscally constrained conditions as the gross government debtexceeding 100
percent of GDP and/or government deficit in excess of 6 percent of GDP. Both of
these are present in the case of Ireland. On average, the study shows that
consumption response to fiscal stimulus is negative-to-zero following the
stimulus, but becomes positive in the medium term. Impact on output and investment
is negative. The core reasons for the adverse effects of fiscal expenditure on
economic performance are losses from stimulus through increased imports of
goods and services by the State, internal re-inflation of the economy through
inputs prices, plus the expectation from the private sector consumers and
producers of higher future taxes required to cover public spending increases.

In the case when financial
crisis is present, increase in Government spending results in a positive and
strong output expansion, rise in consumption and, with some delay, rise in
investment. However, net exports still fall sharply and the stimulus leads to
the inflationary loss of external competitiveness in the economy.

The problem with the above
results is that the IMF study still does not consider what happens to a fiscal
stimulus in a country like Ireland, combining a strict currency peg, exclusive
reliance on trade surplus for growth generation and characterized by
historically high levels of fiscal imbalances and financial system collapse. In
other words, even the IMF research as imprecise as it is, is far from
conclusive.

These are non-trivial problems
in the case of Ireland. Official estimates for fiscal policy multiplier in this
country range between 0.38 (European Commission) and 0.4 (Department of
Finance). These are based on relatively
simplistic models and are, therefore, likely to be challenged by the reality of
our current conditions. A more recent study from the Deutsche Bank cites Irish
fiscal multiplier of 0.3 without specifying the methodology used in deriving
it. Either way, no credible estimate known to me puts the fiscal multiplier
above 0.4 for Ireland.

In short, Government stimulus
is not exactly an effective means for raising output, even at the times when
the economy can take such stimulus without demolishing the Exchequer balancesheet.
And lacking precision in estimating the fiscal multiplier, the entire argument
in favor of fiscal stimulus is an item of faith, not of scientific analysis.

In my opinion, Ireland does
not need a Government expenditure boost. Instead we need a policy shift toward
stimulating domestic and international investment, plus the public expenditure
rebalancing away from current spending toward some additional capital
investment.

Quarterly National Accounts
clearly show that the problem with the Irish economy is not the fall off in
private or public consumption, but a dramatic collapse in private investment. While
private consumption expenditure in Ireland has declined 13.6% relative to the
economy’s peak in 2007, net expenditure by Government is down 12.0% (including
a decline in public investment). However, overall private investment in the
economy is down 67%. 2011 full year capital investment was, unadjusted for
inflation, at the level last seen in 1997, while consumption is down ‘only’ to 2005-2006
levels and Government spending is running at around 2006 levels. With nominal
GDP falling €33.5 billion between 2007 and 2011, our investment declined €32.6 billion
over the same period, personal consumption dropped €12.8 billion, while net
Government expenditure on goods and services is down a mere €3.4 billion. Between
2007 and 2011, total voted current expenditure by the Government rose 12%,
while total net voted capital expenditure fell 44%.

Adding a Government investment
stimulus of €2 billion would have an impact of raising net capital expenditure
by the Exchequer in 2012-2014 to the levels 22.4% below those in 2007 and will
lift our GDP by under 1.8% according to the EU measure of fiscal multiplier.
However, factoring in deterioration in the current account as estimated by the
IMF, the net effect might be closer to zero. Based on IMF model
re-parameterized to our current conditions, the net result can be as low as
0.1% increase in GDP.

Again, the problem here is the
effect of capital spending on our imports. As a highly open economy, Ireland
imports most of what it consumes. This includes Government and private capital
investment goods – machinery, materials and know-how relating to construction,
assembly, installation and operation of modern transport systems, energy and
ICT, etc. Some of these imports will continue well beyond the period of actual
investment. In other words, using fiscal stimulus to finance public capital
investment risks providing some short-term supports for lower skilled Irish
labour and few professionals with the lion’s share of expenditure going to the
multinational companies supplying capital goods and services into Ireland from
abroad.

The fiscal cost of such a
stimulus, however, would be exceptionally high. Between 2008 and 2011, Irish
Government has managed to cut €4.3 billion off the annual capital spending bill
while increasing current spending by €662 million. This resulted in total voted
spending reduction of only €3.6 billion. A stimulus of €2 billion on capital
investment side will throw the state back to 2009 levels of expenditure,
erasing two years worth of consolidation, unless it is financed out of cutting
current spending and transferring funds to capital programmes. The extra
capital spending will lead to further retrenchment in private consumption and
investment, as households and businesses will anticipate relatively rapid
uplift in tax burdens to recover the momentum to the fiscal consolidation.
This, coupled with already committed €8.6 billion in further fiscal adjustments
in the next three years, will further reduce growth effects of the stimulus and
shorten its positive effects duration.

Overall, the right course of
policies to pursue today requires restructuring of the debt burden carried by
the real economy, starting with household debts and stimulating, simultaneously
domestic and foreign investment into small and medium enterprises and
start-ups. Instead of focusing on the less labor-intensive MNCs’ investments,
we need to put in place tax and institutional incentives to increase inflow of
equity capital, not new debt, to Irish businesses. Such incentives must target
two areas of investment: investment into activities associated with new jobs
creation by the SMEs, plus investment into strategic repositioning and
restructuring of Irish SMEs to put them onto exporting path.

Lastly, if we really do want
to have a stimulus debate, the discussion should not be focusing on creating a
net increase in the public expenditure, but on the potential for reallocating
some of the funds from the current expenditure side of the Exchequer
balancesheet to capital investment.

Box-out:

The latest
Index of Failed States published this week ranks Ireland the 8th
best state in the world. Our overall score in the league table was helped by
extremely high performance in some specific indicators. Surprisingly, according
to the Index authors, we are having a jolly good time throughout the crisis. Allegedly,
Ireland’s problem in terms of emigration is relatively comparable to that found
in New Zealand and Germany. Our economy, heavily dominated by MNCs exports in
pharma, medical devices and ICT sectors ranks higher in terms of the balance of
economic development than majority of the advanced economies that have more diversified
and domestically anchored sources of growth. Our ‘balanced development’ model,
having led us into the current crisis, is allegedly more sustainable, according
to the Index, than that of Canada – a country that escaped the Great Recession.
In terms of poverty and economic decline we are better off than France, Japan
and New Zealand, which had a much less severe recession than Ireland over the
last 5 years. In quality of public services, we are better than Belgium and the
UK, and are ranked as highly as Canada. And our elites are less factionalized
than those in the vast majority of the states of the Euro area. In short,
according to the Foreign Policy, index
publisher, Ireland is a veritable safe haven within a tumultuous euro zone,
comparable to New Zealand, Luxembourg, Norway and Switzerland. We rank well
ahead of Canada, Australia, the UK and the US, as well as all other states that
currently receive tens of thousands of Irish emigrants.

Disclaimer

This blog represents my personal views and is not reflective of the views or opinions held by any company, contractor, client or employer I work for currently or have worked for in the past. These views are not an endorsement to take any action in the markets or of any political position, figures or parties.

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